Tuesday, October 23, 2012

Overeating at the Big Government Restaurant

We’ve all been in this situation before – we are at a restaurant with a group sufficient in size to make separate checks untenable.  We may be fooled the first time we try to economize, ordering pasta (no sauce) and water, only to be stuck with a proportionate share of a bill that includes your dining companions’ martinis and filet mignons.  But we’re not fooled the second time, and in a savvy crowd, no one at the table is fooled – and as a result we all end up sucking down martinis and filling our arteries with coagulated cow fat to the tune of sharing a bill for an order that is triple what we would have chosen in isolation.  Economists call this a Lindahl equilibrium – with 10 people at the table, you only face 1/10th of the incremental cost of your personal order, and yet you get to eat the whole damn thing.  Everyone else has the same calculation running through their heads, and the feeding frenzy ensues, followed by the ever-increasing credit card balance.

This is one of the standard models used to explain pork-barrel spending in Congress.  When a congressperson brings some boondoggle project into his district, his constituents face only a fraction of its costs, and yet receive all the benefits of the federal funds flowing in.  The voter fails to see that this was part of an equal trade among the 400+ members of Congress, so in the end he is paying the same small fraction for 400+ projects that do not benefit the district, and in effect he is on the hook for the entire cost of the boondoggle.  Or, if the voter is savvy, he still sees that if his congressman doesn’t play this game while all of the others do, he now pays his proportionate share for all of these projects, and none of the pork comes home.  He therefore comes to the conclusion that although this game sucks, he wants his congressman to play it.  But just as in the case of the restaurant, you get things you never wanted in the first place, and you are worse off as a result.

This is one big argument against Big Government – the dynamics are such that we are all stuck at Ruth’s Chris steakhouse scanning the menu for the most expensive item, rather than the one we would actually choose given our own budget.  But I was reading an interesting blog post that highlighted a paper by Ed Prescott, which points out an even more pernicious way in which Big Government leads to a perverse Lindahl equilibrium. 

Prescott was trying to understand why Americans work much harder than Europeans.  In standard labor economics, an increased tax rate would have an ambiguous effect on the amount of labor you would ideally provide in the market.  By lowering the amount of take-home pay for working an hour, there is a substitution effect – because you are not taxed for sitting on the couch and watching professional bowling, you may lower the number of hours you work and take-in more exciting 7-10 splits.  However, there is a countervailing income effect – with a higher tax rate, you have to work harder to achieve any specific goal you may have, such as retiring by a certain age.  Maybe you work more (income effect dominates), or maybe you work less (substitution effect dominates).  Liberals who press for bigger government are always and everywhere counting on the income effect at least holding its own.  If you cut back your hours as they raise the tax rate, the revenue may not increase and may even go down – i.e. they are killing the golden goose.

Prescott’s insight was to look at what the government does with the tax revenues raised.  If it simply finances parties at the Kennedy estate, there is no benefit that flows back to the guy making the labor decision.  Raising his taxes yields the substitution effect and the income effect, and it’s close to a wash.   If, however, the new tax revenues go to providing things to that worker that he otherwise would have had to pay for himself out of his post-tax pay, there is very little income effect from the increased tax.  So if the government decides it’s going to give out TV’s, and this guy just happens to have been saving for a TV, wala – no income effect – he can cut back his work without giving up the TV.  The substitution effect dominates, and hours go down.  Now, the total tax revenues from this guy may increase or decrease depending upon how many hours are cut back versus the extent of the incremental tax increase.  But even if they increase slightly, they’ve done so in a context where the government has just committed to giving out TVs to 300 million people, so it is likely that the revenues fall short of the promised incremental goodies.

Now think back to the feeding frenzy at the restaurant.  The government promises you something you would otherwise have to pay for on your own, and that promise doesn’t require that you pay a certain amount in taxes.  You can work harder, or keep your hours the same, and therefore increase your tax revenues, or you can cut back your hours, but the effect of your labor decision doesn’t matter as much for what you get to spend as it did prior to the tax increase.  Everyone is making the same calculation we did at the restaurant – compared to the situation prior to the tax rate increase, working harder doesn’t add as much to what we get in the end, and working less doesn’t subtract as much from what we get in the end. 

Think of the extreme – suppose the government committed to providing you all of your needs – food, shelter, clothing, entertainment, etc.  No matter what anyone else does, if you stop working, you reduce the amount you get from the government by your 1 share of 300 million in tax revenues to buy crap to give away – your decision to stop working has only an incremental effect on what you get from the government, but you just reduced your tax payment to zero.  You get the full benefit of not paying any part of the bill, and yet this individual decision has basically zero effect on what the government doles out to you.  Just like at the restaurant, only now we are talking 300 million people at the table rather than 10, everyone is savvy enough to make the same individually rational decision that is collectively disastrous – stop working.  No work, no tax revenues, and no goodies.

That’s the basic explanation offered by Prescott – because the European welfare states provide so many things people would otherwise have to pay for themselves, they reduce their individual price for such goodies by cutting back their labor supply.  The substitution effect dominates. 

So suppose the government says – you shouldn’t have to worry about paying for a lawn gnome, we will provide one to everyone.  Prior to making that promise, and try to hold your laughter, let’s suppose the current tax revenues are sufficient to handle all current commitments, so that to provide lawn gnomes to the entire population the government has to increase tax revenues, and does so by increasing the rates.  The substitution effect kicks in undiluted by the income effect.  Because everyone is working less, there is less stuff.  Even if the government still manages to balance its budget, there is less stuff!  Big Government’s decision to provide the lawn gnome in the end only makes you watch more professional bowling instead of buying your own lawn gnome, as well as a pink flamingo lawn ornament.  But this is not a better situation – prior to the tax increase, you explicitly decided that owning the pink flamingo lawn ornament was better than watching bowling.  Everyone loses, with the possible exception of the bowlers!

One lesson, which has always been the standard conservative message, is this – if government spending is a big waste (and of course we argue much of it is), it makes us all poorer just because we are flushing money down the toilet – but it may have no effect on how much work we do and how much we produce.  It’s just that the government somehow manages to take all that money and piss it away on stupid stuff we would never spend it on ourselves.  So it is like we’ve made all of these lawn gnomes, and the government just collects them and trades them with another country for something incredibly tacky that we would never ourselves choose.  But the better lesson from Prescott is this – if government spending is actually on things we want, like the lawn gnomes, it still makes us poorer!  Whether the government is throwing money away or it is successful in providing to us the things we want – the government is making us poorer!

When you decrease the benefits from working longer and harder, and increase the benefits from not working at all, you have the makings of an unsustainable long-term fiscal policy.  You’ve promised things, and by virtue of that promise alone you have decreased the size of the pie to the point where you will be unable to honor that promise.  Each incremental extension of the welfare state brings us closer to that breaking point.  (And by welfare state I do not mean programs for the poor exclusively – it is the pernicious genius of liberals to have created programs that encompass everyone, like Social Security and Medicare.)

The “substitution effect” of big government is not restricted to labor decisions.  Prior to the emergence of the welfare state, the economies were much more agrarian, and the physical toll of the work was such that families had to rely upon their grown children to maintain the output of the farm.  Kids, and the mutual obligations of family, were the “social security” of the prior era.  Now, instead, we finance those retirement years through taxing the current generation of workers.  The economies of Europe went from a situation in which they intuitively understood they had to rear the next generation in order not to starve to death in their old age to one in which the government has now promised citizens that you could never work more than 40 hours a week and still retire at 55, regardless of whether you had any kids.  Based on that, Europe stopped having kids, and now there is no working generation that can be taxed to deliver on the promise.

Many of the European economies – Greece, France, Spain, and Italy - are seeing this dynamic play out in real time.  The promises made government have depressed both work effort and birthrates.  As Mark Steyn puts it, the problem is not that socialism has run out of other people’s money to spend, it’s that it’s run out of people period.  The fallout will not be pretty.  As a country, I think we are unfortunately headed in the same direction.  Our government has been making promises it cannot possibly maintain, people have organized their lives to some extent around such hollow promises, and everyone will be embittered when the promises are broken.  To deflect the blame for such broken promises, Democratic politicians will continue to perpetuate the fiction that you are being screwed by someone other than them – be it the rich, big Oil, big Pharma, outsourcing, etc.  You are not being screwed by anyone other than Big government. 



Anonymous Anonymous said...

Sitting at a meeting here at API, I can tell you that big oil never screwed anyone.

12:07 PM  

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